The Winds Of Winter: Chinese Structural Reforms

Since the great financial crisis, the best and most dangerous lesson, rational investors like myself have been forced to learn is to never underestimate the devastating combination of central government power and public aversion towards painful outcomes.

When the US market turned down in 2011, the Fed responded with QE2. When the European Sovereign debt crisis came to a head in 2012, Draghi did whatever it takes. When Japan suffered a massive earthquake and ran its first trade deficit, Abe and Kuroda responded with QQE and Abenomics.

Governments and central banks around the world have prevented market forces from correcting artificial trends. The longer this goes, the more accepting market participants are of these outrageous and extraordinary actions. When looking at each event with virgin eyes, one gets a much better picture of the dire situation the world finds itself in today.

Perhaps there is no place in a more precarious position right now than China, whose 35 year credit fueled bubble is coming to an end. A long time ago, China decided to peg its currency to the dollar. At the time it was smart, because the US was exporting lots of debt and devaluing the dollar for almost thirty years. By pegging the Yuan, to the dollar, China could soak up US debt and at the same time enjoy a depreciating currency that benefitted it’s exports driven economy.

But now the Chinese are discovering the double edged nature of the Yuan’s peg to the dollar. With the dollar strengthening against the Yuan for the first time in decades, capital is fleeing China in record amounts and the wonderful FX war chest, China has built up over the decades is draining faster than Saudi Arabia’s. To make matters worse, the PBoC has been forced to engage in one of the worst trades in history. They are selling US treasuries which are rallying, and using the dollars they get to buy a depreciating currency, the Yuan, with which they use to buy falling equities, the Chinese stock market. On every aspect of that trade, the PBoC is coming out a loser. Yes it buys them time, but as we’ve seen, it’s not enough, and it appears that the PBoC and the CCP have both realized this.

And now for the first time, in a LOOOOOONG time, we are hearing government officials discuss the dreaded “Structural Reforms“. And it’s not some developed western nation but members of the Chinese Communist party. It seems, at long last that the Chinese both plebeian and party member alike can see that the current systems is not working. This turning point, in the Chinese narrative cannot be understated.

A quick excerpt reads:

Q: What are the major tasks of supply side structural reform?

A: The five major tasks include reducing production capacity, unloading inventory, de-leveraging, lowering cost and filling the short board of the economy.

Deleveraging is the path to a recession. Deleveraging leads to debt writedowns, which leads to losses, which leads to hate which leads to rebellion which leads to the dark side! Star Wars references aside, the fact that China’s leaders are willing to discuss structural reforms as an important part of China’s near future should be very scary for the already beaten up financial markets, because baby they ain’t seen nothing yet. A few percentage points off the Yuan don’t make much of an impact. But another 10-15% or even greater decline, now that will have some serious impact. And let’s not forget the drop in global demand that would follow any Chinese write-downs or structural changes.

The fact remains that China hasn’t even begun to deal with its structural reforms and the global financial markets are already reeling. Now that China has publicly committed to structural reforms, it’s only a matter of time before the real pain starts. The main trades here are deflationary and risk off related. US treasuries and dollars are screaming BUY. Tech stocks, emerging market equities and high yield or low grade corporate debt are just among the many things screaming SELL. 2016 is quickly shaping up to be a year with more landmines than firm ground. Be careful where you step.

 

 

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